TOKYO (Reuters) -Japan's Daiichi Sankyo announced on Friday a $5.5 billion agreement with Merck to jointly develop its three precision cancer drug candidates, in a deal that could generate $16 billion more depending on their success.

All three candidates belong to the class of drugs known as antibody drug conjugates (ADC) and are in various stages of clinical development for the treatment of multiple solid cancer tumors. Unlike conventional chemotherapy, which can kill healthy cells, ADCs are designed to spare healthy cells while targeting cancer.

The three have "multi-billion dollar worldwide commercial revenue potential for each company" by the mid-2030s, the two companies said.

Under the deal, Merck will pay Daiichi Sankyo a $4 billion upfront payment in addition to $1.5 billion in continuation payments over the next two years. Merck may make additional payments of up to $16.5 billion contingent on future sales milestones.

Shares of Daiichi Sankyo surged in Tokyo trade and were up 12% at 0046 GMT.

Daiichi has six ADC candidates in its pipeline, including one jointly developed with AstraZeneca.

As a result of the agreement, Merck will take a pretax charge of $5.5 billion, or approximately $1.70 per share, reflecting the upfront payment and the continuation payments, resulting in a reduction in fourth-quarter and full-year 2023 results, the statement said.

Merck's investment in the pipeline assets and costs to finance the transaction will also result in a negative impact to earnings per share of about 25 cents in the first 12 months following the close of the transaction, the statement added.

(Reporting by Kanjyik Ghosh in Bengaluru and David Dolan in Tokyo; Editing by Subhranshu Sahu, Leslie Adler and Jamie Freed)